“A much more nebulous conception”

Chris Joye's reply to my last post on housing provides a neat segue into the broader topic of why I entered the public debate on economics in the first place. It was because in December 2005, I became convinced that a major global economic crisis wasabout to hit. I felt that someone had to raise the alarm, and that—at least in Australia—I was probably that somebody.

Two years later, that crisis did hit. Called "the Global Financial Crisis" by Australians and "the Great Recession" by Americans, it is now universally regarded as the worst economic crisis since the Great Depression.

The vast majority of economists were taken completely by surprise by this crisis—including not just Chris Joye and the ubiquitous "market economists" that pepper the evening news, but the big fish of academic, professional and regulatory economics as well.

As late as June 2007, the Chief Economist of the OECD observed that:

the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe … In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment. (Jean-Philippe Cotis, 2007, p. 7; emphases added)

In Australia, the Reserve Bank was equally confident that the future was rosy, both locally and globally:

Economic data in Australia over recent months have signalled a pick-up in the pace of growth in demand and activity… These conditions have been accompanied recently by higher-than-expected underlying inflation.

Growth of the Australian economy has for some time been assisted by favourable international conditions. Current expectations of official and private-sector observers are that the world economy will continue to grow at an above-average pace in both 2007 and 2008. (RBA, August 2007, p. 1; emphasis added)

The award for the worst timing has to go to Oliver Blanchard, founding editor of the American Economic Association's specialist journal, AER: Macro. On August 12, 2008, Blanchard published a glowing overview of conventional macroeconomics:

For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time however, largely because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism and herding. None of this deadly however. The state of macro is good. (Olivier Blanchard, 2009p. 210; emphasis added, Olivier J. Blanchard, 2008)

How wrong they were. The economic and financial crisis that is now the defining social context of our times began months after the OECD declared the future "benign", days after the RBA predicted above average growth, and one year before Blanchard's hapless paean. Unemployment rose rather than fell—dramatically so in the USA. Four years later, US unemployment remains stubbornly high, despite the biggest economic stimulus packages in history, while recent data even shows an uptick in unemployment in Australia, the OECD country that has weathered the crisis with the least damage to date.

Firstly, they believe that the private sector is rational in everything it does, including the amount of debt it takes on. For this reason, Ben Bernanke, the neoclassical "expert" on the Great Depression, ignored Minsky's Financial Instability Hypothesis:

Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior. [A footnote adds] I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go. (Ben S. Bernanke, 2000, p. 43; emphases added.)

Secondly, they believed that the level of private debt—and therefore also its rate of change—had no major macroeconomic significance:

Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects… (Ben S. Bernanke, 2000, p. 24; emphases added)

Finally, the most remarkable reason of all is that debt, money and the financial system itself play no role in conventional neoclassical economic models. Many non-economists expect economists to be experts on money, but the belief that money is merely a "veil over barter"—and that therefore the economy can be modelled without taking into account money and how it is created—is fundamental to neoclassical economics. Only economic dissidents from other schools of thought, like Post Keynesians and Austrians, take money seriously, and only a handful of them—including myself (Steve Keen, 2010; http://www.economics-ejournal.org/economics/journalarticles/2010-31)—formally model money creation in their macroeconomics.

Even the most "avant-garde" of neoclassical economists, like Paul Krugman, have only just begun to consider the role that debt might play in the economy:

Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models—especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy. (Paul Krugman and Gauti B. Eggertsson, 2010, p. 2)

Even when he attempted to break from this mould, Krugman did so from the same point of view as Bernanke above—that the level of debt doesn't matter, only its distribution, and that one can abstract completely from how money is created:

Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth -- one person's liability is another person's asset… In what follows, we begin by setting out a flexible-price endowment model in which "impatient" agents borrow from "patient" agents [where what is borrowed is not money, but "risk-free bonds denominated in the consumption good"], but are subject to a debt limit… (Paul Krugman and Gauti B. Eggertsson, 2010, pp. 3 & 5)

In contrast, I have dedicated my academic life to extending the Financial Instability Hypothesis first developed by Hyman Minsky, and for that reason I was always aware that private debt plays a much more important role in the economy than neoclassical economists comprehend. Having been given the task of explaining (in an Expert Witness Report) how enforcing a predatory loan could have deleterious consequences for people who were not parties to the loan, I therefore turned immediately to the level and rate of growth of private debt.

What I saw in December 2005 shocked me. Though five years earlier, when writing Debunking Economics, I had commented that I expected a debt-induced financial crisis at some stage in the future (Steve Keen, 2001, pp. 311-312), the sheer scale and rate of growth of debt was staggering. The 40-year long trend for private debt to rise 4.2% faster than GDP simply couldn't be sustained forever, and I felt that its breaking was imminent. When it broke, I expected that the Australian economy would enter a slump that would be far worse than that of the early 1990s (I'll discuss why I was wrong on this expectation later).

I quickly checked the US data to see whether this was merely an Australian phenomenon, or a global one. The private debt to GDP ratio was growing more slowly in the USA—though over a much longer timeframe (at an average 2.25% p.a. since 1945). The US's ratio was almost twice as high as Australia's, and five times as high as it was at the end of WWII.

Figure 3: A five-fold increase in US private debt to GDP since 1945

When these trends of rising private debt ended, I felt we were certain to experience an economic downturn whose severity would be unprecedented in the Post-WWII period—and which could even rival the Great Depression.

The reason why I believed that a change in the rate of growth of debt could cause a crisis, while conventional economists (in which category I include everyone from Paul Krugman and Ben Bernanke to Chris Joye) saw no problem with a higher level of private debt, is because the economic tradition to which I belong acknowledges that the growth in private debt boosts aggregate demand. When a bank lends money, it creates spending power by creating a deposit at the same time. This additional money adds to spending power of the borrower, without reducing the spending power of savers.

Neoclassical economics, on the other hand, treats banks as simple intermediaries between savers and lenders. A loan therefore increases the spending power of the borrower, but reduces the spending power of the saver.

If the neoclassical model of banking were correct, then the macroeconomic effects of debt would be muted, as Bernanke and Krugman argued. However, there is overwhelming empirical evidence that this model is wrong. This evidence was first comprehensively analysed by the American Post Keynesian economist Basil Moore (Basil J. Moore, 1979, 1988a, 1995, 1988b, 1997, 2001, 1983), but it was also recognized by the then Senior Vice-President of the New York Federal Reserve, Alan Holmes, in 1969. While explaining why the Monetarist-inspired attempt to control inflation by controlling the growth of the money supply had failed, Holmes quipped that "In the real world, banks extend credit, cre­at­ing deposits in the process, and look for the reserves later“.

At more length, Holmes summed up the Mon­e­tarist objec­tive of con­trol­ling infla­tion by con­trol­ling the growth of Base Money as suf­fer­ing from “a naive assumption”:

that the bank­ing sys­tem only expands loans after the [Fed­eral Reserve] Sys­tem (or mar­ket fac­tors) have put reserves in the bank­ing sys­tem. In the real world, banks extend credit, cre­at­ing deposits in the process, and look for the reserves later. The ques­tion then becomes one of whether and how the Fed­eral Reserve will accom­mo­date the demand for reserves. In the very short run, the Fed­eral Reserve has lit­tle or no choice about accom­mo­dat­ing that demand; over time, its influ­ence can obvi­ously be felt”… [and] “the reserves required to be main­tained by the bank­ing sys­tem are pre­de­ter­mined by the level of deposits exist­ing two weeks ear­lier.” (Holmes 1969, p. 73) (Alan R. Holmes, 1969, p. 73; empha­sis added.)

Why did neo­clas­si­cal econ­o­mists ignore this per­fectly sen­si­ble analy­sis, and the host of empir­i­cal evi­dence sup­port­ing it accu­mu­lated by Moore and oth­ers, includ­ing even neo­clas­si­cal standard-bearers like Kyd­land and Prescott (Finn E. Kyd­land and Edward C. Prescott, 1990, p. 4)? I would like to say that “faced with a choice between real­ity and their assump­tions, neo­clas­si­cal econ­o­mists chose their assump­tions”, but strictly speak­ing that wouldn’t be true. The vast major­ity of neo­clas­si­cal econ­o­mists have no idea that this empir­i­cal evi­dence even exists. But if they had heard of it, most of them would have dis­missed it any­way because it under­mines numer­ous core beliefs in neo­clas­si­cal eco­nom­ics, includ­ing the belief known as Wal­ras’ Law. This is because, once it is acknowl­edged that the growth in credit can expand aggre­gate demand, then:

The nom­i­nal amount of money mat­ters, and bank­ing & debt dynam­ics have to be included in macro­eco­nomic mod­els, while neo­clas­si­cal eco­nom­ics ignores them.

The neat sep­a­ra­tion of macro­eco­nom­ics from finance can no longer be main­tained, since the change in debt finances pur­chases of assets, as well as pur­chases of newly pro­duced goods and services.

Worst of all, the belief that every­thing hap­pens in equi­lib­rium has to be aban­doned. Ris­ing debt is not nec­es­sar­ily bad—in fact it is an essen­tial aspect of a grow­ing economy—but it is nec­es­sar­ily a dis­e­qui­lib­rium process, as Schum­peter argued long ago (Joseph Alois Schum­peter, 1934, pp. 95, 101).

Work­ing from the per­spec­tive that the econ­omy is dri­ven by aggre­gate demand, and that aggre­gate demand is GDP plus the change in debt, I there­fore expected the cri­sis to begin when the rate of growth of debt slowed down sub­stan­tially. In August 2007, when the RBA pub­lished its opti­mistic fore­cast for 2007 and 2008, I pub­lished the fol­low­ing obser­va­tion on the Aus­tralian economy:

Reduc­ing the rate of growth of debt from its cur­rent level of 15% to the seven per cent rate of growth of nom­i­nal GDP would mean a reduc­tion in spend­ing next year, com­pared to the cur­rent trend, of over $100 bil­lion. That is equiv­a­lent to an eight per cent reduc­tion in aggre­gate demand com­pared to trend, and would have the same impact on the econ­omy as a ten per cent fall in nom­i­nal GDP. This real­i­sa­tion is why I first observed in early 2006 that an even­tual reces­sion is inevitable—and why, in mock hon­our of Keating’s famous phrase, I gave it the moniker of “The Reces­sion We Can’t Avoid”. (Steve Keen, 2007, p. 37)

That hypo­thet­i­cal process began in the USA in early 2008 (though Aus­tralia did in fact avoid that recession—a point I dis­cuss later). Aggre­gate demand fell sharply in 2008 even though debt was still ris­ing; then in mid-2009 the change in debt actu­ally turned negative.

Fig­ure 4: A slow­down in the rate of growth of debt caused the Great Reces­sion

Since aggre­gate demand deter­mines employ­ment, the rate of unem­ploy­ment exploded as the debt-financed por­tion of aggre­gate demand collapsed.

Fig­ure 5: Change in debt-financed demand and unem­ploy­ment, USA

Since debt finances asset pur­chases as well as pur­chases of goods and ser­vices, I also expected the turn­around in the growth of debt to cause asset mar­kets to tank as well—which they did, in spec­tac­u­lar fashion.

But here the cau­sa­tion was complex—because as well as ris­ing debt caus­ing asset prices to rise, ris­ing asset prices also encour­age would-be spec­u­la­tors to enter the stock and hous­ing mar­kets with bor­rowed money. There was there­fore what engi­neers call a “pos­i­tive feed­back loop” between the change in asset prices, and debt.

This aspect of cap­i­tal­ism is com­pletely abstracted from by neo­clas­si­cal eco­nom­ics, since its macro­eco­nomic analy­sis only con­sid­ers the buy­ing and sell­ing of newly pro­duced com­modi­ties. To con­sider it prop­erly, we have to tran­scend the core con­cept of neo­clas­si­cal think­ing, Walras’s Law.

The Schumpeter-Minsky Law

The cor­ner­stone of the Neo­clas­si­cal barter model of cap­i­tal­ism is “Walras’s Law”. To cite the Wikipedia here, “Wal­ras’ Law hinges on the math­e­mat­i­cal notion that excess mar­ket demands (or, con­versely, excess mar­ket sup­plies) must sum to zero. That is, Sum[XD] = Sum[XS] = 0″.

The essence of Wal­ras’ Law is the propo­si­tion that, to be a buyer, one must first be a seller—so that the source of all demand is sup­ply. In an envi­ron­ment of free exchange where it is assumed that most mar­ket par­tic­i­pants were “nei­ther thieves nor phil­an­thropists”, neo­clas­si­cal econ­o­mists asserted that “the net value of an individual’s planned trades is iden­ti­cally zero” (Robert W. Clower and Axel Lei­jon­hufvud, 1973, p. 146). A seller was assumed to only sell in order to buy, and to expect a fair return, so that the sum of each person’s sup­ply would equal that person’s demand. Call­ing the gap between a person’s demand and sup­ply “excess demand”, neo­clas­si­cal econ­o­mists asserted that:

Sev­enty years ago, the great evo­lu­tion­ary econ­o­mist Joseph Schum­peter argued that Wal­ras Law was false in a credit econ­omy, because credit gave entre­pre­neurs spend­ing power that did not come from the sale of exist­ing goods.

An entre­pre­neur, in Schumpeter’s model, was some­one with an idea but no money to put it into prac­tice. How does such a per­son actu­ally get the money, Schum­peter mused?

whence come the sums needed to pur­chase the means of pro­duc­tion nec­es­sary for the new com­bi­na­tions if the indi­vid­ual con­cerned does not hap­pen to have them?(Joseph Alois Schum­peter, 1934, p. 72)

After rul­ing out the con­ven­tional answer that it came solely from sav­ings on partly quan­ti­ta­tive and partly log­i­cal grounds, Schum­peter observed that:

there is another method of obtain­ing money … the cre­ation of pur­chas­ing power by banks… It is always a ques­tion, not of trans­form­ing pur­chas­ing power which already exists in someone’s pos­ses­sion, but of the cre­ation of new pur­chas­ing power out of noth­ing … which is added to the exist­ing cir­cu­la­tion. (Joseph Alois Schum­peter, 1934, p. 73)

The capac­ity for banks to cre­ate money endogenously—“out of nothing”—is cru­cial here. Given this capacity—which Schum­peter took as obvi­ous, and which later empir­i­cal work has shown to be the case—aggregate demand is greater than aggre­gate sup­ply, with the dif­fer­ence being accounted for by the change in debt.

Schumpeter’s stu­dent Min­sky added to this the obser­va­tion that the growth of debt was nec­es­sary to sup­port a grow­ing economy:

If income is to grow, the finan­cial mar­kets, where the var­i­ous plans to save and invest are rec­on­ciled, must gen­er­ate an aggre­gate demand that, aside from brief inter­vals, is ever ris­ing. For real aggre­gate demand to be increas­ing, … it is nec­es­sary that cur­rent spend­ing plans, summed over all sec­tors, be greater than cur­rent received income and that some mar­ket tech­nique exist by which aggre­gate spend­ing in excess of aggre­gate antic­i­pated income can be financed. It fol­lows that over a period dur­ing which eco­nomic growth takes place, at least some sec­tors finance a part of their spend­ing by emit­ting debt or sell­ing assets. (Hyman P. Min­sky, 1982, p. 6; empha­sis added)

Min­sky also pointed out that the entre­pre­neur is not the only one who gets spend­ing power this way: so too does the Ponzi Financier, the spec­u­la­tor who attempts to profit by buy­ing and sell­ing assets on a ris­ing market:

A Ponzi finance unit is a spec­u­la­tive financ­ing unit for which the income com­po­nent of the near term cash flows falls short of the near term inter­est pay­ments on debt so that for some time in the future the out­stand­ing debt will grow due to inter­est on exist­ing debt. Both spec­u­la­tive and Ponzi units can ful­fill their pay­ment com­mit­ments on debts only by bor­row­ing (or dis­pos­ing of assets). The amount that a spec­u­la­tive unit needs to bor­row is smaller than the matur­ing debt whereas a Ponzi unit must increase its out­stand­ing debts. As a Ponzi unit’s total expected cash receipts must exceed its total pay­ment com­mit­ments for financ­ing to be avail­able, via­bil­ity of a rep­re­sen­ta­tive Ponzi unit often depends upon the expec­ta­tion that some assets will be sold at a high enough price some time in the future. (Hyman P. Min­sky, 1982, p. 24; empha­sis added)

Min­sky thus inte­grates the dynam­ics of asset mar­kets with Schumpeter’s vision of a credit-based econ­omy, in which an impor­tant com­po­nent of aggre­gate demand comes from the endoge­nous expan­sion of spend­ing power by the banks. This yields an account­ing iden­tity which is true in a credit-based econ­omy, whereas Wal­ras’ Law is only true in the neo­clas­si­cal fic­tion of a pure barter econ­omy (David Grae­ber, 2011).The “Schumpeter-Minsky Law” is thus that:

The sum of all incomes plus the change in debt equals the rev­enue the sale of goods and ser­vices plus net asset sales.

The change in debt is thus related to the cur­rent level of eco­nomic activity—on both com­mod­ity and asset markets—which explains the cor­re­la­tions shown ear­lier between the rate of change of debt, the level of out­put (and hence of unem­ploy­ment), and the level of asset prices.

An obvi­ous second-order impli­ca­tion of this—first explored sta­tis­ti­cally by (Michael Biggs et al., 2010; see http://ssrn.com/paper=1595980)–is that the accel­er­a­tion of debt is related to the rate of change of out­put, unem­ploy­ment, and asset prices. Enter “the neb­u­lous con­cep­tion” that Chris Joye derided, the “Credit Accel­er­a­tor”: It is a log­i­cal con­se­quence of a credit-based view of how cap­i­tal­ism functions.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.

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